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Theories of Bank Loan
Commitments
by O. Emre Ergungor
Introduction
Bank loan commitments—contractual promises
to lend to a specific borrower up to a certain
amount at prespecified terms—are widely used
in the economy. A recent Federal Reserve sur-
vey shows that 79 percent of all commercial
and industrial lending is made under commit-
ment contracts.1 Moreover, as of March 2001,
outstanding (unused) loan commitments of
U.S. corporations exceeded $1.6 trillion, up
from $743 billion in 1990.2
As the use of loan commitments has grown,
so has the literature on them. This article seeks
to summarize what we have learned after years
of research and to determine whether we have
a reasonable idea of what value loan commit-
ments provide to borrowers and lenders.
Two features of loan commitment contracts—
various fees, which must be paid over the life
of the commitment, and the material adverse
change (MAC) clause—turn out to be particu-
larly important in theoretical models.3
The fee structure may include a commitment
fee, which is an up-front fee paid when the
commitment is made, an annual (service) fee,
which is paid on the borrowed amount, and a
usage fee, which is levied on the available
Economic Review 2001 Q3
O. Emre Ergungor is an economist at
the Federal Reserve Bank of Cleveland.
This article was originally an essay in
his doctoral dissertation. He is grateful to
Professor Anjan Thakor and Assistant
Professor Sugato Bhattacharyya of the
University of Michigan for their guidance
and thanks Joseph Haubrich, James
Thomson, and an anonymous referee
for many valuable suggestions.
unused credit. A loan commitment contract sel-
dom includes all three kinds of fees together.
Booth and Chua (1995) study a sample of
1,347 loans and find that only 46 percent had
a commitment fee, 38 percent had an annual
fee, and 69 percent had a usage fee. A loan
commitment without a fee structure is rare
but possible.
The second important feature, the MAC
clause, grants the bank some measure of dis-
cretion over whether to honor the contract.
A typical MAC clause reads: “Prior to [loan]
closing, there shall not have occurred, in the
opinion of the Bank, any material adverse
change in the Borrower’s financial condition
■ 1 Board of Governors of the Federal Reserve System, “Survey of
Terms of Business Lending,” Federal Reserve Board Statistical Releases,
E.2 (June 2000)
<http://www.federalreserve.gov/releases/E2/200008/e2.pdf>.
■ 2 Federal Deposit Insurance Corporation, Statistics on Banking,
table RC-6 (August 2001)
<http://www.fdic.gov/bank/statistical/statistics/0103/cbrc06.html>.
■ 3 Because banks do not disclose the features, such as the fee
structure, of the commitments they are selling, the loan commitment
literature contains few empirical papers. Consequently, this article focuses
on theoretical models.
 3
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Economic Review 2001 Q3

from that reflected in its annual report for its
fiscal year ending December 31, ____, or in the
Borrower’s business operations or prospects.”
Note that a bank may repudiate the contract
based solely on its own opinion about a bor-
rower’s financial condition. That is, the clause
allows the bank to use its private information
about the borrower, which outsiders may be
unable to verify.
To show what a typical loan commitment
looks like, table 1 provides a sample of 15 loan
commitments. To give a more informative
picture, Shockley and Thakor (1997) study a
sample of 2,513 variable-rate loan commitments,
offering funds at a fixed markup over a market
interest rate, purchased by very large firms.
Table 2 presents their summary statistics.
Shockley and Thakor find that the market
interest rate used is usually prime or LIBOR (the
London interbank offered rate). The borrowing
firm is offered takedown alternatives of prede-
termined markups over several different indexes,
such as Treasury, federal funds, CD, and A1/P1
commercial paper rates. These authors also
observe that although few commitments carry
all three fees, many combine a usage fee with
either a commitment fee or an annual fee.
I organize this review around three main
questions. Because these are very general,
however, the literature has divided them into

T A B L E 1

Sample of 15 Loan Commitment Contracts

Fees (basis points)

Credit limit Annual
Commitment buyer (millions of dollars) Stated use Commitment servicing Usage Take-down alternatives

Turner Broadcasting 200 Commercial paper backup 0 0 62.5 Prime + 75, LIBOR +175, CD + 187.5
Levi Strauss 500 Debt repayment/consolidation 12.5 0 0 Prime, LIBOR + 100, CD + 112.5
Safeway Stores 480 Debt repayment/consolidation 0 0 0 Prime
Seagull Energy 60 Debt repayment/consolidation 0 12.5 17.5 Prime, LIBOR + 87.5, CD + 87.5
Blockbuster
Entertainment 200 General corporate purposes 0 12.5 12.5 Prime, LIBOR + 50, CD + 62.5
J.C. Penney 750 General corporate purposes 0 0 18.75 Prime, LIBOR + 37.5
AT&T 6,000 Takeover 79.17 13 0 Prime, LIBOR + 37.5, CD + 50
Union Pacific 550 General corporate purposes 0 0 15 Prime, LIBOR + 25, CD + 37.5
UAL Corporation 1,300 Leveraged buyout 157.64 0.69 50 Prime + 100, LIBOR + 200
John Fluke Manufacturing 37.5 Stock buyback 0 0 0 Prime, LIBOR + 50, CD + 50
Universal Corporation 150 Working capital 0 14.17 0 Prime, LIBOR + 37.5
Dunkin’ Donuts 35 Working capital 28.57 0 37.5 Prime, LIBOR + 100
L.A. Gear 150 Working capital 0 0 50 Prime + 100
R.H. Macy & Co. 600 Working capital 150 4.84 50 Prime + 150, LIBOR + 250
American Oil and Gas 20 Working capital 0 0 50 Prime, LIBOR + 300

SOURCE: Greenbaum and Thakor (1995).

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Economic Review 2001 Q3

T A B L E 2

Summary Statistics of a Sample

of 2,513 Loan Commitments

Mean, (Standared deviation), [Minimum–Maximum]

Interest rate mark-up
(basis points) Fees (basis points)
N Size Duration
Stated use (percent of total) (millions of dollars) (months) Prime + LIBOR + Upfront Annual Usage

Commercial 42 557.5 39 45.8 47.8 3.1 6.2 11.4

paper backup (1.7) (800.5) (16.3) (26.0) (37.8) (8.7) (7.9) (17.9)
[30–4,300] [11–84] [25–75] [12.5–175] [0–50] [0–25] [0–62.5]
Liquidity 857 56.9 28.4 115.6 135.4 24.2 6.1 22.8
(34.1) (148.7) (22.3) (73.2) (81.4) (52.0) (18.7) (25.5)
[0.1–2,000] [1–126] [–75–500] [9–350] [0–366] [0–200] [0–400]
Capital 470 142.6 39.7 115.6 148.4 28.6 3.6 27.8
structure (18.7) (352.0) (26.8) (64.4) (82.8) (56.7) (10.6) (21.3)
[.2–5,500] [3–121] [–50–450] [15–425] [0–550] [0–100] [0–125]
General 931 179.1 38 105.6 90.6 18.6 4.5 19.6
corporate (37.0) (449.2) (27.7) (72.9) (77.2) (49.3) (11.0) (19.8)
purposes [.1–6,000] [1–198] [–50–500] [15–425] [0–550] [0–135] [0–100]
Takeover 65 74.6 36.2 111.3 125.1 13.8 3.2 29
(2.6) (136.6) (25.2) (82.3) (80.3) (26.5) (8.5) (20.1)
[0.3–845] [3–120] [12.5–450] [12.5–325] [0–100] [0–40] [0–50]
Leveraged 137 139.3 65.2 149 244.6 89.8 4.2 40.3
buyout (5.5) (288.4) (26.4) (32.6) (43.5) (88.3) (9.6) (19.0)
[1.5–1,848] [11–122] [75–400] [80–475] [0–302] [0–54] [0–62.5]
Debtor-in- 11 120 14.2 188.6 293.7 112.8 16.7 43.18
possession (0.4) (100.9) (8.6) (30.3) (31.5) (106.8) (44.5) (16.2)
[3.3–250] [1–30] [150–250] [250–325] [0–235] [0–150] [0–50]
SOURCE: Shockley and Thakor (1997), table 1.

smaller, related questions: On the first main question, presented in this

1) Why do loan commitments exist and how article’s section I, the essence of what we know
are they priced? is that loan commitments are a contractual
a) Why do borrowers demand them? mechanism for optimal risk sharing when bor-
b) Why do banks offer them? rowers are risk averse and future interest rates
c) Why are loan commitments sold by are random. Even under universal risk neutral-
banks and not by individuals or other ity, loan commitments may still be used to
financial intermediaries? attenuate moral hazard or resolve precontract
d) Are loan commitments put options? informational asymmetry. On the valuation
e) Why are loan commitments not exer- question, the principal insight is that loan com-
cised up to the credit limit? mitments can be priced as put options where
2) How do loan commitments affect the the borrower’s debt is the underlying deliver-
bank’s risk exposure? able. The main findings are summarized below:
a) How should the bank’s risk exposure • Borrowers demand loan commitments
be managed? because
b) Do loan commitments affect the – Loan commitments prevent banks from
bank’s risk exposure? exploiting borrowers and extracting
c) Should loan commitments be rents by threatening to withhold credit;
regulated? – Loan commitments can prevent market
3) How do loan commitments affect the failure by attenuating moral hazard
interest rate and rationing channels of and resolving precontract informational
monetary policy? asymmetry.
 5
• Banks sell loan commitments because
– Loan commitments facilitate forecasting
future loan demand;
– By honoring discretionary loan commit-
ments, banks may enhance their repu-
tation for keeping their promises and
charge higher fees for future promises;
– Lenders may use the fee structure of
loan commitments as a screening
mechanism for distinguishing among
borrowers with a priori unobservable
characteristics.
• Loan commitments are sold by banks
alone because
– It is more costly for an organization not
to honor its contractual commitments than
it is for an individual;
– Reserves that the bank keeps to fund
unexpected demand deposit withdrawals
can also be used to fund unexpected loan
commitment takedowns. Therefore,
deposit-taking institutions have a cost
advantage over other financial inter-
mediaries in issuing loan commitments.
• Loan commitments can be priced as put
options where the underlying deliverable is
the debt instrument of the commitment
buyer.
• Borrowers limit their loan takedown because
banks penalize borrowers that fully exploit
their put options with higher future fees.
The second main question, presented in
section II, asks about the effect of loan com-
mitments on the bank’s risk exposure. In
selling fixed-interest-rate loan commitments,
banks assume the risks associated with three
uncertain quantities: the future level of interest
rates, the borrower’s uncertain credit needs,
and the borrower’s future creditworthiness.
The issues are how a bank can manage these
risks and whether loan commitments should
be regulated to protect the deposit insurer. The
main conclusion is that banks have the tools
they need (for example, the MAC clause) to
protect themselves against the risks involved in
selling loan commitments. There is little theo-
retical or empirical support to justify regula-
tion. The important findings are:
• The bank cannot fully hedge against interest
rate and takedown-quantity risks through
financial futures contracts.
• Loan commitments reduce the bank’s risk
exposure by inducing it to manage its credit
portfolio better.
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Economic Review 2001 Q3
• Capital requirements, imposed on loan com-
mitments by regulators to protect the deposit
insurer, are not needed because loan com-
mitments with a MAC clause do not impose
any additional credit risk on the bank.
The third main question, presented in
section III, deals with loan commitments’
effects on the transmission of monetary policy.
Monetary policy is conducted through quantity
rationing and interest rate channels by altering
the quantity of credit and its price, the interest
rate. Loan commitments help attenuate rationing
by providing a guarantied source of funds,
and thus reduce monetary policy’s ability to
affect bank lending. The main finding is:
• Loan commitments introduce significant lags
in the effect of monetary policy.
While the current literature improves our
understanding of loan commitments consider-
ably, some stylized facts remain unexplained.
First, courts limit banks’ use of discretionary
powers, often ruling that a bank’s use of the
MAC clause is an abuse of power and lack of
good faith. (See Goldberg [1988], Mannino
[1994], and Budnitz and Chaitman [1998]). If
the MAC clause is so difficult and costly to
exercise, then why do banks continue to incor-
porate it into contracts? Second, moral hazard
in spot lending, which can be resolved by loan
commitments, can also be resolved through
relationship (repeated) lending (Sharpe [1990],
Rajan [1992], Petersen and Rajan [1995], and
Boot [2000]); why, then, do we have loan com-
mitments? I discuss these and other unresolved
issues briefly in the final section of this article.
I. The Purpose and
Pricing of Loan
Commitments
I will investigate the existence and pricing
literature in four subsections. First, I will dis-
cuss why borrowers demand loan commit-
ments (demand-side explanations). Then, I
will explain why banks sell loan commitments
(supply-side explanations). Next, I will focus
on the question of why banks alone sell loan
commitments. Finally, I will recapitulate what
we know about the similarities between loan
commitments and put options.
 6
Demand-Side
Explanations
The literature has suggested five benefits that
loan commitments offer purchasers.4
Loan Commitments
Improve Risk Sharing
between the Bank and
the Borrower
When a bank sells a fixed-rate loan commit-
ment, it accepts the interest rate and quantity
risk that the borrower would bear if he were to
borrow in the spot market. Borrowers who are
more risk-averse than the bank are willing to
pay the bank a premium for taking the interest
rate risk on their behalf. In Campbell (1978),
the premium is the usage fee. In Thakor and
Udell (1987), it is the commitment fee. With a
fixed-rate commitment, the bank bears the risk
of changes in the index rate as well as of
changes in the borrower’s credit risk premium.
With a variable-rate commitment, the bank
bears only the latter risk. I will further investi-
gate this issue in section II, where I discuss the
bank’s risk exposure.5
Loan Commitments
Help Attenuate
Moral Hazard
With risky debt and limited liability, the higher
the loan interest rate, the lower the borrower’s
net return from a project and the greater his
incentive to switch to a riskier project (Boot,
Greenbaum, and Thakor [1993]) or to under-
supply effort (Boot, Thakor, and Udell [1987,
1991]). To illustrate this concept, consider the
following example.
There are two periods and three points in
time {0,1,2}. At time 0, the borrower knows that
he needs funds next period (t =1) to invest in
one of two mutually exclusive projects {h, l }.
Each project requires a $1 investment, which is
assumed to be financed by a bank loan. The
projects have the following characteristics: If
the project is successful with probability µ i ,
it generates a cash flow Xi , i{h,l } and zero
otherwise. It is also assumed that Xh > Xl and
µ h < µ l . Hence, l is a low-risk project and h is
a high-risk project. It is further assumed that
Xl µ l >Xh µ h . That is, the low-risk project is
socially optimal. At time 0, the market interest
rate at time 1 is random. It can be shown that
when the market interest rate at time 1 is
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Economic Review 2001 Q3
greater than (Xl µ l – Xh µ h ) ( µ l – µ h ) –1, the
borrower prefers the risky project as a con-
sequence of limited liability.6
Boot, Thakor, and Udell (1987, 1991) and
Boot, Greenbaum, and Thakor (1993) propose
the following solution to this problem. At
time 0, the bank sells the borrower a loan
commitment with a fixed interest rate of
R = (Xl µ l – Xh µ h ) ( µl – µh ) –1.
If the market interest rate is less than R, the
borrower is free to use the market. Otherwise,
he exercises his option and takes down the
loan from the commitment contract. Hence,
the loan commitment guarantees that the bor-
rower always chooses the safe project. Note
that the bank suffers a loss when the borrower
exercises the option. To break even, the bank
charges a commitment fee at time 0 equal to
the expected loss to the borrower at time 1.
Also note that because the commitment fee
becomes a sunk cost at time 1, when the bor-
rower makes the investment decision, it does
not affect the borrower’s incentives.
Boot, Thakor, and Udell also show that loan
commitments are more effective than equity
investment in attenuating moral hazard. The
intuition is as follows: When a borrower
invests in equity, he reduces his interest bur-
den for all realizations of future interest rates.
This is clearly inefficient because low interest
rates are not distortionary, yet the equity still
reduces the payment burden in those states.
The effect of a loan commitment, on the other
hand, is selective across interest rates. When
market rates are low, the borrower can still
benefit from them. The loan commitment
reduces the interest burden only when market
rates are high. Therefore, the commitment fee
required to mitigate moral hazard is less than
the equity investment needed to create the
same effect.
■ 4 Some of these benefits arise from the possibility of solving
information problems by using the multiple-fee structure. Clearly, these
papers could be reviewed as part of the pricing literature discussed at the
end of section I, but I prefer to group all the demand-side explanations in
a single section.
■ 5 Also see Hawkins (1982) and James (1982).
■ 6 (Xl l –Xh h ) (l – h )–1 is the rate at which the borrower’s
expected profit from the safe project equals its expected profit from the
risky project if the lender believes that the borrower will invest in the safe
project and prices the loan accordingly. In other words, if the spot rate is
greater than this critical value, the lender must believe that the borrower
will invest in the risky project if it borrows from the spot market.
 7
Boot, Thakor, and Udell’s model explains
the commitment fee and the interest rate guar-
anty of loan commitments. Other important
aspects of the contract, such as the multiple fee
structure or the MAC clause, are assumed away
by simplifying modeling choices, which are
summarized below.
One-period simple projects: A sure invest-
ment is made at time t and the outcome is
realized at time t +1. After the loan commit-
ment is purchased, no new information about
the project is revealed to the borrower or the
bank, which may induce parties to renegotiate
or walk away from the deal. This assumption
will be relaxed in the next section.
Homogeneous investors: Every investor has
the same project choice at the time the loan
commitment is negotiated, so problems like
adverse selection are not at issue. This assump-
tion will be relaxed when we discuss the
informational role of loan commitments.
Credible precommitment: In the model of
Boot, Thakor, and Udell, the bank commits
itself to provide a subsidy at time 1 and is com-
pensated for the expected subsidy at time 0.
Note that at time 1, when the market rate is
high, the actual subsidy is greater than the
expected subsidy. Despite the obvious loss,
the bank still honors the commitment. We will
discuss this issue further in the “Loan Commit-
ments Help Banks to Balance Reputational and
Financial Capital Optimally” section, below.
A final caveat: The results of Boot, Thakor,
and Udell apply only to fixed-rate commit-
ments. Within their sample of 2,526 loan
commitments, Shockley and Thakor (1997)
found only 13 (0.5 percent) that had fixed
rates. Therefore, although preventing moral
hazard is a plausible reason for the existence
of loan commitments, it does not seem to be
the driving force behind them.
Loan Commitments
Help Reduce Other
Investment Distortions
Moral hazard created by debt financing is
not limited to the asset-substitution problem
described above. Loan commitments also
address overinvestment, underinvestment, and
suboptimal liquidation problems. From a
modeling point of view, papers in this category
use Boot, Thakor, and Udell’s “tax now, subsi-
dize later” idea but relax the “simple-project”
assumption.
Consider a project with two investment
periods, 0 and 1.7 At time 0, the time-1 invest-
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Economic Review 2001 Q3
ment is random. A risk-neutral borrower con-
siders only the expected time-1 investment and
takes the project at time 0 if the expected net
present value (NPV) is positive. With equity
financing, the time-0 investment is a sunk
cost at time 1, so the borrower continues the
project if the expected terminal cash flows
exceed the second-period investment. With
debt financing, however, the borrower pro-
ceeds differently. He repays the initial loan
when cash flows are realized at the end, so
the initial investment is not sunk and causes
underinvestment if the repayment obliga-
tion is sufficiently large.
A loan commitment with a usage fee
reduces the borrower’s payment burden from
the first-period loan without negative profit
implications for the bank. The usage fee, paid
on the available unused credit, compensates
the bank for the interest rate concession, but
its incidence is selective across borrowers.
More fortunate investors, with lower second-
stage requirements, pay more because of the
gap between their borrowing and the credit
limit of the loan commitment. Investors with
higher second-stage requirements pay smaller
fees because their borrowing is closer to
the credit limit. That is, borrowers with low
funding needs subsidize the less fortunate
borrowers, giving not-so-lucky—but still
profitable—investors an incentive to proceed
with their projects.
In a similar setting, Houston and
Venkataraman (1996) further relax the “simple-
project” assumption and analyze the firm’s
liquidation decision. This time, the equity-
financed firm compares its liquidation value
at time 1 to future cash flows and liquidates if
the liquidation value is greater. With short-
term debt, the initial investment is not sunk,
but is a liability to be covered by the expected
payoff. The firm liquidates when the debt
obligation (not the liquidation value) is greater
than the expected payoff. As a result, bond-
holders receive the liquidation value, which is
less than the expected payoff. Thus, short-term
debt leads to too-frequent liquidations. With
long-term debt, firms never liquidate when the
firm’s liquidation value is less than the initial
borrowing, because the liquidation value goes
to bondholders. Thus, long-term debt causes
too-infrequent liquidations.
A short-term loan with a loan commitment
for future funding alleviates the problem. The
■ 7 This example is from Berkovitch and Greenbaum (1991).
 8
bank gives an interest rate subsidy and reduces
the borrower’s debt burden. This solves the
too-frequent liquidation problem. The bor-
rower compensates the bank with a commit-
ment fee. However, because the fee must also
be financed ex ante, the amount of debt that
the firm must issue at the outset increases as
well. This offsetting effect limits commitments’
ability to reduce the costs of suboptimal
liquidations.
One problem with this explanation is that
the subsidized interest rate on the initial loan
may cause overborrowing. Shockley (1995)
points out that a loan commitment that includes
a MAC clause mitigates this distortion; the com-
mitment interest rate can be set low enough to
prevent debt overhang, while the MAC clause
allows the bank to prohibit excessive reinvest-
ment. As usual, the bank breaks even with the
commitment fee.8 Shockley provides evidence
that loan commitments reduce the cost of debt.
Therefore, the capital structure of firms that use
loan commitments is tilted in favor of more debt.
In all the papers discussed above, the bank
provides a sufficiently low interest rate and
the borrower always takes the right action.
However, these papers do not consider an
important question: If the bank commits itself
to provide a subsidy, can the borrower exploit
that commitment and extract rents from
the bank?
Houston and Venkataraman (1994) address
this question.9 Banks acquire private infor-
mation about their borrowers, which enables
them to extract rents from successful firms by
threatening to withhold further credit.10 This
reduces the borrower’s effort input, which
determines the probability that the borrower’s
project will turn out to be good or bad ; that is,
the project will have safe and positive NPV or
risky and negative NPV. By providing a pre-
arranged source of funds, loan commitments
limit the lender’s ability to extract rents from
successful projects. However, when the bank
commits itself to lend, two problems arise. The
borrower may exploit the commitment and
extract rents from the bank by threatening to
liquidate when the project is good and contin-
uing when liquidation is more advantageous.
More specifically, when the project is bad, the
borrower refuses to liquidate unless the bank
is willing to share the liquidation value with
the borrower. With a loan commitment, the
bank charges a sufficiently high interest rate
to induce liquidation. Note that this argument
contradicts previous papers that found that
banks reduced the interest rate by using a loan
commitment to prevent debt overhang. How-
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Economic Review 2001 Q3
ever, as I explain next, loan commitments
create a selective debt overhang problem in
this model. Houston and Venkataraman
assume that in a competitive banking mar-
ket, the borrower’s project quality may be
revealed to other lenders with positive proba-
bility. So, although the high interest rate also
hurts the good project, a borrower with a
good project can borrow from another bank
and avoid commitment financing altogether
if his type is revealed. Therefore, the loan
commitment’s high interest rate hurts borrowers
with bad projects that cannot find an alterna-
tive funding source more than it hurts borrowers
with good projects. Selective debt overhang
resolves the moral hazard problem because the
borrower increases his effort supply to avoid
the high interest rate and the bad project.
The literature shows that loan commitments
also solve precontract information problems.
This is what I discuss next.
Informational Role of
Loan Commitments
In this section, I relax the “homogeneous
investors” assumption and introduce borrowers
with unobservable characteristics.
James (1981) is one of the early papers
showing that loan commitment parameters can
be designed to reveal a borrower’s unobserv-
able characteristics. By demonstrating that the
cost of maintaining compensating balances
differs among customers of different credit
quality, James proved that the customer’s
choice of payment option can be an effective
tool in separating borrowers with different
credit qualities.
The observation that loan commitments can
be used as a screening or signaling mechanism
helps clarify a puzzle in the loan commitment
market. Borrowers often purchase loan com-
mitments in order to back up commercial
paper issues. The argument is that loan com-
mitments provide insurance to commercial
paper lenders. If the borrower’s cash flows are
not sufficient to cover its repayment obligation,
it can always take down a loan under the com-
mitment to meet its obligation. The problem
with this argument is the MAC clause. The fact
■ 8 Also see Morgan (1993).
■ 9 I will present a simplified version of the intuition here.
■ 10 See, for example, Rajan (1992).
 9
that the borrower cannot repay its commercial
paper loan is sufficient reason for the bank to
void the commitment. Then why do borrowers
purchase back-up loan commitments? Kanatas
(1987) solved this puzzle.11 He showed that a
loan commitment reduces a corporation’s bor-
rowing cost in the commercial paper market,
not because it provides a guaranty to commer-
cial paper investors but because the purchase
of the loan commitment, along with its associ-
ated price and future borrowing rate, commu-
nicates payoff-relevant information to the com-
mercial paper market.
The intuition is as follows: As of time 0,
there are three possible states at time 1. If the
firm realizes the “good” state, it will be viewed
as an improved credit risk and be able to roll
over its first-period commercial paper at a
lower cost than it would have by exercising
the commitment. Alternatively, the firm may be
in one of the unobservable states in which its
default risk has increased. In the “impaired”
state, the firm’s default probability has
increased in such a way that the commitment-
borrowing rate is lower than the new commer-
cial paper rate and the commitment is exer-
cised to repay the first-period commercial
paper debt. In the “very bad” state, the firm’s
default risk has increased to such an extent
that the commercial paper market denies the
firm further credit and the bank refuses to
honor the commitment. The firm is thus forced
to default. Firms with a greater probability of
exercising the commitment (a higher prob-
ability of being in the impaired state, given that
the default risk has increased) are induced to
purchase a larger commitment. An increase in
the commitment fee (expressed as a percent-
age of the credit line) and a decrease in the
interest rate with increasing probability of the
impaired state is incentive compatible. Firms
with a high probability of being in the impaired
state recognize their greater likelihood of
being able to exercise the commitment advan-
tageously and are therefore willing to pay a
higher fee. Firms with a low probability of
impairment (higher likelihood of the very bad
state) pay a lower fee in exchange for a higher
commitment-borrowing rate in the unlikely
event that they are able to exercise the
commitment.
Deterioration in the borrower’s credit quality
is not the only risk a bank faces. Whether the
borrower will actually take down the loan is
another uncertainty. Thakor and Udell (1987)
show that when the bank does not know bor-
rowers’ takedown probabilities, commitment
and service fees12 induce borrowers to sepa-
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rate themselves through contract choice. One
contract will have a high commitment fee and
a low service fee, whereas the other will have
a low commitment fee and a high service fee.
A borrower with a high takedown probability
will want to avoid a large service fee because
the likelihood of actually paying it is greater.
On the other hand, a borrower with a low
takedown probability is less averse to accept-
ing a high service fee because the likelihood
of actually paying that fee is lower. Such a
borrower would like to minimize the commit-
ment fee because it is a sunk cost that is
incurred regardless of whether he exercises
his commitment option. The borrower with a
high takedown probability finds the large
commitment fee less burdensome because it
represents the price of an option that he is
very likely to exercise. Thus, the difference in
takedown probabilities fundamentally alters
the appeal of varying combinations of commit-
ment and service fees to different borrowers,
inducing each borrower to reveal his type.
The commitment and service fee combina-
tion is not the only screening mechanism.
Shockley and Thakor (1997) develop a ratio-
nale for using commitment and usage fees
jointly. In their model, there are three types of
borrowers: good (G ), medium (M ), and bad
(B ). G is more likely than M to have a profit-
able project and therefore more likely to take
down the loan. B does not have a project to
invest in. The bank wants to lend to G and M
but not to B. In this case, the commitment fee
alone is not enough to separate the types
because if the fee is set to a level at which M
can invest and B does not wish to invest, G
will mimic M although he can pay a higher fee.
Note that the commitment is more valuable to
G than to M because G is more likely to exer-
cise its option. Solving this problem requires
making M’s contract less attractive to G ’s man-
ager. This is achieved by reducing the payoff
to firm M in the state in which the loan is
taken down, by increasing the interest rate.
This increase diminishes the value of the com-
mitment less for M than for G because M has a
lower probability of taking down the loan.
Because the bank operates in a competitive
market, it reduces the commitment fee to
compensate M for the higher interest rate. The
■ 11 Also see Calomiris (1989).
■ 12 The paper refers to usage fees, but it is more accurate to call
fees levied on the borrowed amount service fees.
10
problem is that this simultaneous reduction in
the commitment fee makes the contract attrac-
tive to B . A usage fee makes the contract
expensive for B because he never takes down
the loan. On the basis of their model, Shockley
and Thakor make the following four predic-
tions and provide evidence to support them.
First, if the fee structure helps reveal the bor-
rower’s type, loan commitments should con-
tain a pricing structure with multiple fees when
the firm has assets that are hard to value or
the firm’s credit quality is poor. Second,
there must be a negative correlation between
interest rate markups and usage fees. Third,
announcing a loan commitment purchase
should generate an abnormal positive price
reaction. Fourth, the price reaction must be
greater if the commitment has a multiple fee
structure because the commitment reveals
information about a firm that is hard to value.
Although it is possible to obtain a full sepa-
ration of types by using the multiple fee struc-
ture, this method is limited to two—or at most
three—types. If there are several unobservable
types, the multiple fee structure alone may not
be enough to separate all of them. Thakor
(1989) analyzes this case, deriving the condi-
tions under which a forward contract is more
effective than a spot contract in separating
types. The intuition is that in the forward mar-
ket, the future state of the world is still uncer-
tain. If the relationship among types is such
that, for each type, there is at least one state of
the world where that agent type is the most
likely to attain that state, state-specific subsi-
dies can be used as an additional contracting
variable. For example, at some point in time,
the bank promises an agent of a given type a
subsidized contract in a particular state at the
next point in time. In exchange, the bank
demands a fee at the first point in time. Types
that are less likely to attain that state find the
subsidy too expensive. A separate fee-subsidy
combination can be designed to be the most
attractive for each agent type.
Finally, Duan and Yoon (1993) explain how
loan commitments can be used as a signaling
device. Like Shockley (1995) and Morgan
(1993), Duan and Yoon recognize that the sub-
sidized funds provided by a loan commitment
lead to overinvestment. So the larger a bor-
rower’s credit line is, the higher is the cost of
overinvestment. Note that borrowers with high
success probabilities (high expected profits)
can operate at higher costs than borrowers
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with low success probabilities. Therefore, a
borrower with a high probability of success
can use overinvestment to distinguish itself
from other borrowers, anticipating that it will
be treated favorably in terms of loan pricing.
That is, the credit limit can be used to signal
a borrower’s quality. Once the credit lines are
in place, the firms with higher success proba-
bilities will engage in suboptimal investments
when future spot rates are higher than loan
commitment rates. Thus, the signaling
equilibrium destroys value.
Loan Commitments Give
Borrowers a Strategic
Advantage
Maksimovic (1990) shows that the structure of
the borrower’s industry determines the terms
of loan commitments. In industries with im-
perfect competition, the option to acquire
financing at predetermined rates enhances the
borrower’s strategic position and creates value
for the borrower. A firm that has access to
resources at a lower marginal cost than its
competitors has a strategic advantage that it
can exploit to gain a larger market share and
higher profits. A firm can create such an advan-
tage by purchasing, for a fixed initial fee, an
option to acquire financing on favorable terms.
The ability to exercise the commitment makes
the firm a strategic threat to its rivals and moves
the industry to an equilibrium more favorable
to that firm. Therefore, it is optimal for all
firms to acquire bank loan commitments,
altering the industry equilibrium in the process.
All the models that attempt to explain why
loan commitments exist have two major short-
comings. First, as I noted earlier, the models
that assume a fixed interest rate can justify only
a small fraction of the outstanding loan com-
mitments. Second, models that rationalize the
multiple fee structure as a screening mecha-
nism are applicable only to situations in which
there are at most three unobservable types of
borrowers. Although Thakor (1989) allows for
several types, his model imposes very strong
restrictions on the attributes of types. The
conclusion is that we still have a lot to learn
about the significance of loan commitments’
fee structure.
11
Supply-Side
Explanations
Loan Commitments Help
Lower Regulatory Taxes
for Banks
Regulatory taxes are defined as the costs of
the federal deposit insurance premium, the
constraints placed on increased financial inter-
mediation by regulators’ capital requirements,
and the opportunity cost of maintaining legally
required reserves. It has been argued that off-
balance-sheet activities allow banks to generate
fee income and bypass regulatory taxes. For
example, until the commitment is taken down,
there is no loan, which means that the bank
does not have to collect deposits, keep
reserves, or pay deposit insurance premiums.
Actually, the bank can sell the commitment,
collect the fee, and avoid regulatory taxes al-
together by selling the loan to another bank as
soon as it is originated.13 However, Kareken
(1987) reports that there was no change in
bank regulatory policy of the sort that would
have prompted banks to start issuing loan
commitments suddenly. From April 1969
through mid-1973, the Federal Reserve System’s
reserve requirement schedule was changed
only once, in November 1972, when the aver-
age reserve requirement was decreased. The
effective per dollar deposit insurance premium
was not changed in that period either. In 1971,
there were no minimum capital-asset ratios.
Thus, regulatory taxes fail to explain the exis-
tence of loan commitments.
Loan Commitments
Improve Banks’
Forecasts of Future
Loan Demand
Greenbaum, Kanatas, and Venezia (1991)
suggest that loan commitments reduce banks’
uncertainty about future loan demand and its
attendant costs. In their setting, banks can
borrow after the loan demand is known or by
prearrangement. Prearranged funds can be
obtained at a lower interest rate. Recognizing
their informational disadvantage, banks offer to
share the benefit of their lower funding costs,
provided that clients disclose private informa-
tion regarding prospective credit demand. A
loan commitment contract incorporating a
usage fee and a forward interest rate motivates
honest disclosure of the borrower’s loan
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demand information. The usage fee will be
higher for firms that report higher expected
loan demand, whereas the loan rate offered to
such firms will be lower. The intuition is that
firms with high loan demand are insensitive to
high usage fees because they will most likely
use the entire credit line and not pay the usage
fee. Firms with low loan demand will report
their information truthfully despite the low
interest rate offered to investors with high
demand because they wish to avoid the high
usage fee.
Loan Commitments
Help Banks Balance
Reputational and
Financial Capital
Optimally
Loan commitments are discretionary contracts
because the MAC clause gives the bank the
right to refuse a loan when the borrower
requests it. However, if a bank honors its
commitment even when it is costly to do so,
it can enhance its reputation for keeping its
promises. A good reputation makes its future
commitments more valuable because borrow-
ers are willing to pay a premium for a credible
commitment. Thus, a bank may use the loan
commitment to enhance its reputation.
Boot, Greenbaum, and Thakor (1993) for-
malize this idea. The party that has discretion
gains the option of taking a costly action. If the
cost is sufficiently high, only agents that can
afford to pay the cost can take the action, sig-
nal their types, and improve their reputations.
In Boot, Greenbaum, and Thakor’s model,
future spot rates are uncertain. The bank
promises to give the borrower an interest rate
subsidy if the future spot rate is too high. The
bank is compensated beforehand with a fee
that represents the expected cost of the sub-
sidy.14 The cost of honoring a discretionary
loan commitment is that when the borrower
takes down the loan, the actual subsidy is
greater than the expected subsidy that the
■ 13 Greenbaum (1986) argues that banks became high-cost lenders
because the Federal Reserve and the FDIC ceased to set limits on the rates
that banks could pay to creditors; as a result, banks are burdened by higher
borrowing costs as well as regulatory taxes. However, they still maintain
their cost advantage as raters of borrowers. Hence, they offer loan commit-
ments and then sell the loans they originate.
■ 14 I discussed the same model in the section titled “Loan
Commitments Help Attenuate Moral Hazard.”
12
bank was compensated for when the spot rate
was still uncertain. Therefore, it is costly for a
bank to honor a commitment. Then, high-
quality banks with more economic power than
low-quality banks can signal their type and
improve their reputational capital by honoring
the discretionary contract and reducing their
current financial capital, while low-quality
banks repudiate their commitments, preserve
their financial capital, and forgo the future
benefits of a better reputation. In other words,
a loan commitment helps the bank to manage
its portfolio of financial and reputational
capital optimally.
The idea that banks can use loan commit-
ments as a signaling mechanism has been
empirically verified by Mosebach (1999). His
argument is based on a paper by Billett,
Flannery, and Garfinkel (1995) reporting that
“more reputable” lenders give the market more
new information than “less reputable” lenders
do. Billett, Flannery, and Garfinkel also pro-
pose that firms endeavor to send the strongest
signal possible to the market by using the best
lender. Mosebach argues that large companies,
wishing to send the strongest possible signal to
the market, use the best bank and largest line
of credit available. So the purchase of a loan
commitment transmits the following informa-
tion: First, by selecting a particular bank, the
borrower signals his belief that this is the best
lender available to him. Second, the purchase
communicates to the market new, positive
information about the bank’s current and
future financial position. Mosebach’s findings
show a positive and significant market reaction
to the bank’s stock when the bank grants a
line of credit.
Banks’ Advantages
over Individuals and
Other Institutions
in Providing
Liquidity through
Commitments
If loan commitments have the benefits described
in the previous section, then why do not other
financial intermediaries offer them? The litera-
ture on this question builds on literature deal-
ing with the emergence of organizations. So I
first explain why institutions’ commitments are
more credible than individuals’ and then
describe banks’ advantage over other financial
intermediaries in selling loan commitments.
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Banks Can Commit
Themselves Credibly but
Individuals Cannot
When individuals sign up for the future
delivery of a product or service, they prefer to
contract with a firm or organization rather than
another individual. Thus, individuals buy in-
surance from insurance companies and rarely
from other individuals; loan commitments are
sold by banks and not by individuals. Why
can firms—but not individuals—credibly
commit themselves to supply a product or
service in the future in exchange for current
compensation?
Boot, Thakor, and Udell (1991) offer the
intuition that it is more costly for an organiza-
tion not to honor its contractual commitments
than it is for an individual. In a setting where
risky debt and limited liability create moral
hazard at sufficiently high interest rates, the
lender gives the borrower a subsidized rate to
prevent moral hazard and recovers that sub-
sidy with an up-front fee paid when the com-
mitment is sold. The problem with an individ-
ual lender offering a commitment is that he
can collect the commitment fee, consume his
entire wealth, and repudiate the commitment.
No penalty or other legal enforcement mecha-
nism can remedy the situation. To prevent the
individual lender from consuming his wealth,
an individual banker with a nonconsumable
project endowment can collect this wealth as
a deposit and sell a commitment to the bor-
rower. If the banker repudiates the contract,
a court can seize the banker’s project endow-
ment. The trouble with this setting is that
because the subsidy is provided only when
interest rates are high, the commitment fee
reflects only the subsidy’s expected cost and
therefore is less than the ex post amount of the
subsidy. Therefore, the banker will repudiate
the contract if the loss from honoring it (the
difference between the commitment fee and
the subsidy) is greater than the cost of losing
its project endowment. In contrast, a bank is
made of a countable infinity of individual
bankers (equity holders), each with a project
endowment that will be seized if the commit-
ment is repudiated. Note that in this case, the
loss incurred by each banker from honoring
the commitment is zero because a finite loss is
divided among an infinity of bankers, while
repudiation entails the loss of each banker’s
project endowment. Clearly, the bank always
honors the commitment. Hence, the emer-
gence of organizations prevents market failure
13
that might be caused by individuals not honor-
ing contracts. Although this result is quite
intuitive, it is unclear why individuals cannot
place a fraction of their wealth in an escrow
fund that the courts may seize if the individual
fails to honor his commitment. Such an escrow
fund would easily make individuals’ commit-
ments credible.
Finally, note that the courts play an impor-
tant role in Boot, Thakor, and Udell (1991) by
penalizing bank shareholders when commit-
ments are not honored. Boot, Greenbaum, and
Thakor (1993) ignore the judiciary and show
that reputational concerns may be enough to
induce the banks to keep their promises. How-
ever, reputational concerns are not enough to
explain why banks alone sell loan commit-
ments; an individual might have similar con-
cerns and honor his commitments.
Banks Have a Cost
Advantage over Other
Institutions
It is clear from the previous discussion that
loan commitments will be sold by institutional
lenders. The question is, why must this institu-
tion be a bank and not another form of finan-
cial intermediary? Kareken (1987) argues that
technological advances decreased the cost of
acquiring and processing information, which
opened the direct credit market to a large
number of borrowers. These borrowers, how-
ever, have to be rated and monitored by mar-
ket participants. Kareken assumes that techno-
logical advances created a larger decrease in
banks’ information acquisition costs than in
those of other lenders. Then, purchasing a
bank loan commitment results in lower direct
costs for lending, rating, and monitoring
because the bank assumes the default risk and
does the monitoring. Two objections may be
raised against this argument. First, it is not clear
why technological advances benefit banks
more than they benefit other intermediaries.
Second, Kareken ignores the MAC clause that
relieves the bank of its commitment when the
borrower’s financial condition deteriorates.
Therefore, Kareken’s argument does not explain
why banks alone offer loan commitments.
Kanatas (1987) provides an informal solu-
tion to this puzzle, arguing that only banks sell
loan commitments because they have access to
the discount window. Their ability to meet
unexpectedly high commitment loan demand
with relatively low-cost funds from the dis-
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Economic Review 2001 Q3
count facility makes their expected cost of
funding commitments lower than that of non-
bank competitors. If this subsidy more than
offsets the cost of the reserve requirement,
only banks will sell commitments.
Similarly, Kashyap, Rajan, and Stein (forth-
coming) allude to the cost of the reserve
requirement to formalize the cost advantage
issue and explain why the intermediary selling
the loan commitment must be a bank. They
show why deposit taking and lending activities
are carried out by a single institution (commer-
cial bank) rather than separate institutions.
They argue that loan commitments let a bank
take advantage of economic synergies between
its deposit-taking and lending activities.
Demand deposits and loan commitments both
provide liquidity on demand to bank cus-
tomers who have unpredictable liquidity
needs. If these contracts require costly over-
head in the form of cash and security holdings,
a synergy will exist to the extent that the two
activities can share some of the costly over-
head. A bank that offers both deposits and
loan commitments can get by with a smaller
total volume of cash and securities on its bal-
ance sheet than would two separate institu-
tions, each specializing in only one of the two
functions. Hence, efficiency is enhanced.
Pricing Loan
Commitments
as Put Options
Loan commitments have several similarities to
put options. The commitment buyer pays a
commitment fee for the right to sell a security
to the bank at a prespecified price over some
previously established time interval. The secu-
rity is the commitment owner’s debt, and the
strike price is the dollar amount of the borrow-
ing. The buyer will exercise the put option and
take down the loan if the value of his debt on
the exercise date is less than the committed
loan amount. Clearly, this description excludes
the two most important features of loan
commitments that the literature attempts to
explain: the multiple fee structure and the MAC
clause. Yet, these and other simplifying assump-
tions, which I review next, are needed to apply
the option pricing theory to loan commitments.
14
Thakor, Hong, and Greenbaum (1981)
made the first attempt to rationalize and price
loan commitments as put options.15 Their
paper develops a model for valuing variable-
rate bank loan commitments within the frame-
work of the Black and Scholes methodology.16
It is a preliminary step in the valuation of loan
commitments and therefore ignores several key
factors in order to obtain a valuation formula.
There are four key differences between loan
commitments and exchange-traded put options.
1) Exchange-traded options are binding,
while loan commitments are discretionary
because of the MAC clause.
2) Loan commitments are not transferable.
3) Loan commitments have a different
pricing structure (usage and service fees).
4) A put option is either exercised in full or
not at all. Loan takedowns, however, are
usually only a fraction of the commit-
ment’s face value.
The literature has not addressed the ques-
tion of how the first three points affect the
valuation of loan commitments as put options.
Attempts have been made, however, to explain
the partial takedown phenomenon.
Thakor, Hong, and Greenbaum (1981)
provide the first explanation of the partial take-
down phenomenon. They argue that the future
pricing and availability of bank services are
influenced by the degree to which a customer
exercises his loan commitment, because a gain
for the customer is a loss to the bank. In estab-
lishing the price of the commitment and the
size of the fixed mark-up, the bank considers
expected borrower behavior under alternate
states of the world. If the borrower surprises
the lender by borrowing more than expected,
the lender revises his expectations and adjusts
upward the price and/or the mark-up appli-
cable to future commitment transactions.
Therefore, when the firm chooses the take-
down fraction, it minimizes the expected cost
of the next loan plus the opportunity loss from
not taking down the current loan fully.
In Thakor, Hong, and Greenbaum, the bank
uses an exogenous process for updating the
commitment fee and the fixed mark-up based
on take-down behavior. Greenbaum and
Venezia (1985) endogenize this process by
assuming that the loan amount taken down by
the borrower depends on his productivity,
unobservable to the bank. The borrower’s
productivity is subject to random mean-zero
changes. The bank infers the borrower’s pro-
ductivity from the takedown. High takedown
signals high productivity; this means that high
future takedowns are associated with higher
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net costs to the bank since they imply that the
borrower is exercising his put option more.
As the bank obtains new estimates of the bor-
rower’s productivity, the average of those esti-
mates yields a less noisy signal of productivity,
so price adjustments to unexpectedly high
takedowns become less significant over time.
The interest rate smoothing that results from
the bank–borrower relationship prevents the
borrower from switching to other banks. This
last result, however, depends on the strong, if
not unrealistic, assumption that the new bank
knows nothing about the client’s takedown
history and that new customers are indistin-
guishable from switching customers.
II. The Effects of
Loan Commitments
on the Bank’s Risk
Exposure
I have already mentioned that when a bank
sells a loan commitment, it accepts the interest
rate and quantity risk that the customer would
bear if he were to borrow in the spot market.
Although the commitment fee is expected to
compensate the bank for its risk exposure,
regulators believe that loan commitments
increase the risk exposure of banks and the
deposit insurer. Regulators argue that because
the potential liability of a loan commitment is
not quantified and reflected in the deposit
insurance premium, a bank may be tempted to
take on excessive risk by expanding its loan
commitments, which may result in an under-
estimation of the deposit insurer’s risk expo-
sure. Therefore, regulators have imposed
capital requirements against bank loan com-
mitments to control their growth. Some of the
literature on loan commitments provides
insight on the merit of these arguments.
■ 15 Hawkins (1982) argues that revolving credit agreements (loan
commitments with infinite maturity) are similar to callable bonds. He bases
his argument on transaction costs to rationalize loan commitments.
■ 16 See Thakor (1982) for the valuation of fixed-rate loan
commitments.
15
Early papers (Ho and Saunders [1983] and
Koppenhaver [1985]) asked whether the bank
could use financial futures contracts to hedge
against interest and quantity risks. The main
finding is that unless the spot loan price and
the expected quantity of loan takedowns are
perfectly correlated, the bank cannot hedge its
risks fully. That is, it can hedge against one of
the two variables by buying or selling futures
contracts, but if the two variables are not per-
fectly correlated, a single type of contract is
insufficient to hedge against both types of risk.
Clearly, these early papers took the increase in
banks’ risk exposure as a given and did not
investigate whether loan commitments actually
increase the bank’s risk exposure. Avery and
Berger (1991) and Boot and Thakor (1991)
addressed this issue.17
Avery and Berger argue that selling a loan
commitment is risky because the bank is
locked into lending to a borrower who might
suffer a decline in creditworthiness that would
otherwise dictate a higher interest rate or no
loan at all. To make this argument, they assume
that invoking the MAC clause is costly and the
bank bears the legal costs. However, they do
not clarify why the bank cannot recover
the costs ex ante with the commitment fee.
Because the borrower’s creditworthiness may
change over time, the bank has less informa-
tion about the borrower when the loan com-
mitment is sold than when spot contracts are
signed. This leads to moral hazard. Now, sup-
pose there are borrowers with and without
moral hazard problems. Due to informational
difficulties, the bank may ration moral hazard
borrowers. If those who are rationed and wait
for the spot market are safe borrowers (infor-
mation is revealed in the spot market and
these borrowers can borrow there), the bank’s
loan commitment portfolio consists of riskier-
than-average borrowers and the bank’s risk
exposure is augmented. Otherwise, if moral
hazard borrowers are the risky ones, the
bank’s risk exposure is reduced. Avery and
Berger empirically find that fewer problem
loans and higher bank income are associated
with loan commitments. Therefore, commit-
ments reduce the bank’s risk exposure.
Boot and Thakor (1991) find that loan com-
mitments lower bank asset portfolio risk for
two reasons: First, the loan commitment con-
tract can be designed to resolve the asset sub-
stitution problem between the bank and the
borrower.18 Second, if the bank’s existing spot
loan portfolio in a given period is observable
to its loan commitment customers in that
period, then optimally the bank will choose to
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Economic Review 2001 Q3
make spot loans to less risky borrowers. The
intuition is that the bank’s current loan com-
mitment revenue is an increasing function of
the likelihood that the bank will be solvent in
the future when it will honor the commitment.
Hence, an increase in the riskiness of its spot
loan portfolio causes a reduction in its loan
commitment revenue. From this result, Boot
and Thakor draw the following important
policy implication: The deposit insurer should
insist that all of the bank’s outstanding commit-
ments be voided if the bank cannot pay off its
depositors and is bailed out by the insurer.
That is, the deposit insurer should transfer
some of the risk to loan commitment cus-
tomers to give them an incentive to monitor
the bank’s spot loan portfolio.
Clearly, the capital requirements that regula-
tors impose on loan commitments to protect
the deposit insurer are not needed because,
unlike other off-balance-sheet liabilities, such
as standby letters of credit for which the bank
acts as a guarantor, loan commitments with a
MAC clause do not impose any credit risk
on the bank. In fact, as Boot and Thakor show,
they lower the bank’s asset risk when the bank’s
loan portfolio is observable to customers.
III. Loan Commitments
and Monetary Policy
Regulators conduct monetary policy through
quantity rationing and interest rate channels by
altering the quantity of credit and its price, the
interest rate. Tighter monetary policy creates a
reserve shortage that raises the cost of funds to
banks. When their cost of funds rise, banks
raise loan rates, which causes businesses and
consumers to cut down expenditures. The
interest rate channel implies a relationship
between monetary policy and bank loan rates,
loan volume, and economic activity. The quan-
tity rationing channel refers to the possibility
that when banks’ funds costs rise, they choose
to reduce the volume of loans above any
reduction caused by an increase in interest
rates on loan demand. This channel implies a
direct link between monetary policy and the
quantity of bank loans.
■ 17 Hassan and Sackley (1994) showed empirically that loan
commitments reduce a bank’s risk exposure.
■ 18 See the discussion on moral hazard in section I.
16
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Since loan commitments protect borrowers banks acquire private, firm-specific information
from quantity rationing, in the short run, mon- during their relationship with borrowers and
etary policy changes will affect loans under exploit their informational advantage relative
commitment only through the interest rate to other lenders to earn positive profits in the
channel (Duca and Vanhoose [1990], Morgan future.19 An important implication is that banks
[1994], and Woodford [1996]). If monetary are willing to take losses early if they expect to
policy tightens, banks resort to rationing cus- recover them in the future. In a setting like
tomers without commitment agreements this, a bank can give the borrower a subsidy
(Sofianos, Wachtel, and Melnik [1990] and with a standard debt contract and recover the
Glick and Plaut [1989]). In the long run, as loan subsidy from future transactions rather than
commitments expire, quantity rationing appears with the commitment fee. So it is not clear why
in the form of refusing to renew a commitment a borrower would choose a loan commitment
or reducing its size. Therefore, loan commit- over a spot loan or vice versa. Therefore, we
ments introduce significant lags in the effect of need a model that rationalizes loan commit-
monetary policy (Deshmukh, Greenbaum, and ments in a relationship setting.
Kanatas [1982] and Morgan [1998]). Finally, a loan commitment is an incomplete
contract. Important issues, such as loan maturity
and debt covenants, are left open to negotia-
IV. Concluding tion and are finalized before the loan closes.
Remarks Although loan commitments have been metic-
ulously scrutinized, we know nothing about
I have provided a summary of what we know the properties of loans made under commit-
about loan commitments after years of research. ment. How much the final loan agreement
Although we have gained some understanding differs from the terms specified in the loan
of what value loan commitments provide, our commitment deserves further investigation.
knowledge has clear limitations. For example,
in many instances, economists’ conclusions
depend on the use of fixed-rate commitments,
which are rather uncommon in the market. In
papers where loan commitments can be used
to distinguish between borrowers with a priori
unobservable characteristics, the results are
limited to settings where there are at most
three unobservable types, which is far too
restrictive.
There is still much to be learned about loan
commitments. I conclude by briefly reviewing
three of the major unresolved issues.
First, the courts have often obstructed
banks’ right to invoke the MAC clause and
deny credit to a loan commitment owner,
arguing that the banks had not acted in good
faith (Edelstein [1991] and Budnitz and Chaitman
[1998]). That is, the courts have often inter-
preted banks’ use of the clause as an abuse of
power. This is at odds with the current litera-
ture, which views the MAC clause in loan com-
mitments as providing the bank discretion that
has economic value (Boot, Greenbaum, and
Thakor [1993]). Courts’ reasons for intervening
and the welfare effects of their intervention
remain to be understood. ■ 19 Boot and Thakor (1994) show that long-term relationships are
Second, the analysis of loan commitments feasible even without the learning component. In their model, the bank
has been limited to models where, in most initially lends with a secured contract (collateral is costly) at a high
interest rate. Once the borrower succeeds, future loans are unsecured and
instances, the bank collects a fee at time 0 and
subsidized. This feature induces the borrower to work hard at the outset to
in return provides a subsidy at time 1. Unfor- succeed as soon as possible. In contrast to Rajan’s (1992) relationship
tunately, all these models ignore the fact that setting, in which the borrower is subsidized initially and taxed later, in
bank loans are relationship loans. That is, Boot and Thakor taxation occurs before the subsidy.
17
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